In Adar Bays, LLC v. GeneSYS ID, Inc., the New York Court of Appeals (the “Court”) held that the conversion price in a convertible option could be classified as interest thereby potentially falling under the territory of New York’s criminal usury laws.
In 2016, Adar Bays provided GeneSYS with a $35,000 loan in exchange for a note with a one-year maturity date and eight percent interest. This note contained an option for Adar Bays to convert, in whole or in part, the debt amount into shares of GeneSYS stock at a discount of 35% from the lowest publicly traded price over the 20 days prior to the conversion request. Six months and four days after issuance of the note, Adar Bays sought to convert $5,000 of the debt into shares of GeneSYS stock. This request was rejected and litigation commenced with Adar Bays alleging breach of contract by GeneSYS and GeneSYS moving to dismiss the case on the grounds that the loan violated New York’s criminal usury laws.
The federal district court rejected GeneSYS’s argument that the contract should be held as void due to the loan’s rate of interest exceeding the criminal usury rate of 25%. Upon a favorable ruling in Adar Bays’ favor, GeneSYS appealed and on appeal the Second Circuit noted that many federal district courts have not classified similar conversion options as interest under New York’s usury laws but some New York state courts did include future contingent payments in the analysis. With this distinction in mind, the Second Circuit certified two questions to the Court:
- Whether a stock conversion option permits a lender, in its sole discretion, to convert any outstanding balance to shares of stock at a fixed discount should be treated as interest for the purpose of determining whether the transaction violates N.Y. Penal Law § 190.40, the criminal usury law; and
- If the interest charged on a loan is determined to be criminally usurious under N.Y. Penal Law § 190.40, whether the contract is void ab initio pursuant to N.Y. Gen. Oblig. Law § 5-511.
The Court decided both of these questions in the affirmative.
The Court started with the second question and provided a thorough analysis of New York’s civil and criminal usury laws, as well as a history of usury laws in New York. The Court examined the interaction between the civil and criminal usury statutes and held that while the civil statutes do not provide corporations a defense of usury, a violation of the criminal usury statutes can be used by a corporation as defense in a civil case. Further, while the criminal usury statutes do not expressly say usurious loans are void and unenforceable like the civil statutes do, the Court held it was the legislatures intent that a violation of the criminal usury statutes results in the loan, both principal and interest, being void and unenforceable.
Of additional importance, the Court clarified that loans over $2.5 million are not subject to New York’s usury laws.
In analyzing the first question, the Court held that “New York law requires that the value of the conversion option, like all other property exchanged in consideration for the loan, should be included in determining the loan’s interest rate for purposes of the usury statutes, to the extent such value, when measured at the time of contracting, can be reasonably determined. The hypothetical possibility that a future exercise of a floating-price conversion option may result in a return exceeding 25% does not render a loan usurious on its face.”
New York is one of the most popular governing laws for loan documents, in large part because of the fact there is no usury limitation for loans over $2.5 million. However, lenders need to be aware of the possible usury issues with equity options related to loans under $2.5 million. The Court’s ruling suggests that moving forward corporate loans will be looked at with a greater level of scrutiny and that it is likely that defaulting borrowers will raise a criminal usury defense in a civil action resulting from a default on the loan.
Further, it is advisable that, in the future, lenders should keep a detailed ledger moving forward detailing their calculations in the event that the value of a conversion option is questioned. Since the Court held the analysis is based on the intent of the parties at the time the loan was entered into, a lender should evidence its intent that the expected rate of interest present on the loan does not exceed 25% as to not run afoul of the criminal usury laws. Practitioners may also want to consider including a usury provision that states the conversion price shall be deemed modified to the minimum extent required to ensure that the deemed interest is not usurious.
Finally, while New York law is often viewed as the default governing law for loan documents, lenders may want to consider another state’s laws to the extent the locations of the parties permit it. State usury laws vary widely from state-to-state so lenders may be able to rely on a governing law with more flexibility for avoiding usury traps.